It never fails. No sooner does some calamity trigger an urgent need for basic resources than self-righteous voices are raised to denounce the amazingly efficient system that stimulates suppliers to speed those resources to the people who need them. That system is the free market’s price mechanism — the fluctuation of prices because of changes in supply and demand.

Thank you to Anya Quinn on Flickr for the use of this image.

We all reflexively abhor an opportunist, who raises prices on a critical item just when it is needed the most. Yet, pricing is what allows society and its members to make thoughtful judgements on the best use of scarce resources. Read through the article, and ponder a bit.

P.S. – My friend, Melanie, writes PrattleNog, and her blog just got a day’s worth of fame on the WordPress home page. She teaches and works with adult students at Marylhurst University and sometimes teaches a course on Social Media. I noticed that she has been scrupulous about crediting the source of her images, and properly chastened I vowed to emulate her. This particular image is made available for sharing under the Creative Commons licensing site/movement. I’m including the official attribution below, but if you are interested in the whole digital copyright brawl, follow the CC link for more information.

Slate published this article, “Sweet Surrender: Taxing soda to make you stop drinking it.” This is another example of using an excise tax to change consumer behavior. If one believes that there are negative externalities to the consumption of sugar-laden, artificially-flavored, carbonated water, then these taxes fall under the Pigovian Tax label.

From the April 9 edition of The New York Times, comes a report of a public-private solution to the management of commerical fishing stocks off the coast of New England. As with most commercial fisheries, the fish population is declining, due to over-fishing. The Federal Government, through NOAA and regional councils, sets limits on fish catches – hoping to keep fish stocks sustainable. Within those limits, however, fishing boat owners compete to find the fish. Now NOAA is instituting a private ownership system.

In an ownership, or “catch share,” system, individuals, companies, cooperatives, communities or other entities receive the right to take a set percentage of the annual catch of particular fish in particular areas. The system gives fishermen a powerful motive to fish sustainably, because the value of their share rises as fish stocks increase.

The economic concept here is that private ownership will increase the sense of responsibility on the part of group owners, and that they will make decisions to increase the long term value of their ownership investment.

The report mentions an estimate that a 10% rise in cigarette prices results in a 7% drop in smoking among youth and a 4% drop in smoking among adults.

There are a variety of studies on the price elasticity of demand for cigarettes, with varying estimates. The Surgeon General’s office issued a report summarizing the findings from a number of published studies. While the estimates differ some, the difference of elasticity between adults and youth smokers remains significant.

So, let’s review what price elasticity measures. The value of E is the ratio of the percent change in quantity demanded over the percent change in price. For a normal good, E should be negative – i.e. an increase in price yields a drop in quantity demanded, and a decrease in price yields an increase in quantity demanded. In either case one part of the ratio is negative, so the value of E is negative.

The figures reported by NBC (and many of the studies summarized by the Surgeon General’s office) show price elasticity for adults and children to be less than one. More accurately, the absolute value of E is less than 1.0. That means that quantity will change, percentage-wise, less than the change in price. OK – that makes sense. Smoking is understood to be addictive, and so we would expect that smokers might cut down on smoking as prices rise, but not by much.

What, then, is the explanation for youth smokers being “less inelastic”? Perhaps they are less addicted, since their experience with smoking is shorter. They also probably have less disposable income, and so even a modest price rise cuts into their budget more deeply. Are there other explanations?

By the way, the cigarette tax is an excise tax. Given the inelastic demand, we will expect only modest declines in smoking, but the government can expect to generate significant tax revenue.

The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones.

A good accompanying read is the Congressional Budget Office’s preliminary estimate of the impact of President Obama’s proposed budget. (CBO was organized in 1974, to give members of Congress an independent, non-partisan ability to project budgets and their impacts. Previously Congress had to rely on estimates provided by the Executive Branch.) The CBO’s director has started a blog, and this post nicely summarizes the CBO estimates:

As estimated by CBO and the Joint Committee on Taxation, the President’s proposals would add $4.8 trillion to the baseline deficits over the 2010–2019 period. CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.

CBO’s projections of future deficits are higher than those coming from the Administration. The differences are greater than rounding error, and point to the importance of having a separate group crunching the numbers.

The greater question, however, is whether this ballooning Federal deficit is good policy or not. Now back to Robert Frank’s comments. As he points out, there is a kind of quiet consensus that, in the short term, we must endure significant Federal deficits as we try to stimulate demand and climb out of the recession. The greater debate is whether the additional costs proposed by the Administration – that go beyond short term stimuli – are good investments. I happen to think so (in general – more details to learn) and there’s no question that Congress will do more than tinker with the plan. Even so, the deficit estimates are sobering.

Farmers like Mr Errotabere have begun to use water more efficiently, dripping it through perforated hoses rather than flooding fields. There is a growing market in water trades between farmers. Most important, the state has set up a water bank. Farmers north of the Sacramento delta, many of whom grow rice, can offer to keep fallow their least productive lands and sell water to cities and needy farmers farther south.

As the excerpt notes, increasingly scarce water in California’s Central Valley is beginning to be reallocated using some market mechanisms. It isn’t a true market yet – the prices for selling and buying irrigation water is set by a state board. There is a glimmer of hope, though, that consumers of water will start paying something close to water’s value, rather than the historically subsidized fee.As the article points out, Federal and state efforts in the 1930s brought water to a fertile but arid part of California. Water has remained cheap to farmers, and so there was no incentive to use it sparingly. When we drive from Ashland down to the SF Bay Area we pass huge rice fields submerged in water, with what must be huge evaporation loss.

This story in progress points out how, when you want to ration a scarce resource, the best solution is to let the price of that resource reach a level on its own that clears the market, but leaves no surplus or shortage. Not only do we reach an economically efficient solution, but the consumers have an incentive to use the resource wisely.

Thanks to a tip from Greg Mankiw’s blog – we learn that Oregon was the first state to impose a tax on gasoline – back in 1919. This article in Wired describes the interest of the state to fund highway projects, including the Columbia River Highway up the Gorge. So, this isn’t really an example of a Pigovian Tax, which is usually imposed to change behavior.

What do you imagine the price elasticity of demand for gasoline was back in 1919?

The lure of these high profits is so strong that otherwise prudent companies are often tempted to collude. Here is a recent example, reported in The New York Times.

Technology
3 Flat-Screen Makers Plead Guilty to Trying to Keep Prices High
By STEVE LOHR
Published: November 13, 2008

LG, Sharp and Chunghwa Picture Tubes agreed to cooperate in an antitrust investigation being run by the Justice Department.

Three leading flat-screen producers — LG Display of South Korea, Sharp of Japan and Chunghwa Picture Tubes of Taiwan — pleaded guilty and agreed to pay a total of $585 million in criminal fines for their role in fixing the price of liquid-crystal display panels.

The resulting fines are certainly substantial, and yet the potential for increased profits must have outweighed the risks of prosecution. And in this day of ubiquitous communication it is hard to imagine that a secret agreement could stay secret forever.

Here’s an article in today’s Wall Street Journal, that illustrates this point.
Refiners Look to Reduce Production as Falling Gas Prices Cut Into Profits

Here’s the lead

As falling gasoline prices squeeze refining profits, there are signs that refiners are ratcheting back production to pare losses.

Gasoline output, which had been expanding as U.S. refineries came back online after hurricane-related shutdowns, dropped for the first time in weeks, according to data reported last week from the Department of Energy. Philadelphia refiner Sunoco Inc. said last week that it is shutting down a unit used in gasoline production at one of its refineries, though it declined to say why.

a quick excerpt…

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. Too bad for the theory, things don’t seem to work that way.